Cost of short-term financing

The R. Morin Construction Company needs to borrow $100,000 to help finance the cost of a new $150,000 hydraulic crane used in the firm's commercial construction business. The crane will pay for itself in 1 year, and the firm is considering the following alternatives for financing its purchase:

Alternative A: The firm's bank has agreed to lend the $100,000 at a rate of 14 percent. Interest would be discounted, and a 15 percent compensating balance would be required. However, the compensating-balance requirement would not be binding on R. Morin because the firm normally maintains a minimum demand deposit (checking account) balance of $25,000 in the bank.

Alternative B: The equipment dealer has agreed to finance the equipment with a 1-year loan. The $100,000 loan would require payment of principal and interest totaling $116,300.

a. Which alternative should R. Morin select?
b. If the bank's compensating-balance requirement were to necessitate idle demand deposits equal to 15 percent of the loan, what effect would this have on the cost of the bank loan alternative?

Solution Preview

a. Which alternative should R. Morin select?

Alternative A:

In a discount loan, the interest, calculated on the amount borrowed, is paid by the borrower at the beginning of the loan period (in advance). Therefore, the borrower receives less than the face value of the loan.
Where there is a requirement of a compensating balance for advancing the loan, and if the borrower is holding deposit at the bank that is less than the required compensating balance, the difference between the two is deducted at time 0 when advancing the loan (the compensating balance has not been advanced by the bank and is not required to be paid back at maturity).